Sitting Tight

That's right, I have decided to sit tight. The market continues to move higher against me. It is now clearly through my pre-planned stops. Proper risk management states that I should sell down my position. Am I a deer in the headlights? I sure hope not.

The fundamentals continue to suggest the market is past its peak. The housing market keeps getting worse. This has got to start affecting consumer spending at some point soon. Initial unemployment claims so far show the job market is fine, but that cannot carry on forever once spending starts to slow. The credit markets are making good progress at returning to normality, but overall interest rates have not yet returned to where they were a few months ago, even after the Fed easing. The volume of CP outstanding is still shrinking, and apparently some banks are still shut out of the interbank market. Banks have started to unload some of the leveraged loans but the process is only starting and apparently the amount on their books from the big spending spree earlier this year ($300+ billion) is almost as much as the total amount of leveraged loans held by asset managers, etc. It is going to be difficult for all this to be absorbed, and until then, the banks are not going to want to fund new LBOs, hence no more takeover premiums on stocks (despite all the hype about Bear and Sallie Mae today).

Of course this is only speculation but I wonder about the effect of quarter-end tomorrow. Are lots of investors clamouring to get back into the market before they close their books? What other effects might be at work here? Next Monday also marks the start of October, a traditionally difficult month for stocks.

On gold, my entry was clearly timed poorly (I seem to have a knack for poorly timed entries) but I knew this might be the case -- this is why I only started with one unit. Gold continues to hold up well. It has received a lot of media attention recently and everyone seems to like gold, so that is not good from a contrarian standpoint. But I think being a contrarian is more important towards the end of cycles / trends when the consensus has been right for a long time and it cannot get beyond this -- like the case in equities currently. So I am staying long and looking for an opportunity to increase my position on further strength.

I am slightly concerned about the possible tracking error between the TSX and S&P500 indices. I think the present economic environment is more similar to the 1970s then the 1980s or 1990s (the comparisons people are always making). In the late 1970s the TSX performed very well due to the concentration of natural resource stocks, while the S&P went nowhere. If something similar happens again I could end up being right (in that the S&P500 performs poorly) but I lose money. Not the desired objective. I need to keep a close eye on this, and maybe consider diversifying into other short ETFs (e.g. SDS) even if it means taking on some currency risk.

One last point: I took a look at the start of the bear market in 2000 again to see how it played out and if I could relearn anything. One thing that struck me: even though the market peak was reached in March, it was not until late September / October that the S&P decisively moved lower -- 6 months later! In contrast, it has only been 6 weeks since the recent market peak in July. So I am going to wait at least until next week to see how things play out.

MARKET POSITION: EQUITIES - SHORT (4 units); GOLD - LONG (1 unit)

Patience is a virtue

Patience is a virtue in trading. One needs to have patience when entering trades, and patience when exiting. I could do with more patience. I tend to rush into trades, then bail when they do not go my way immediately. I was reflecting on how many of my big ideas over the past 18 months (long DJIA in early '06, long China in mid '06, long gold in late '06, short equities in spring '07) I abondoned then subsequently performed well.

I also rushed to replace the one unit of HXD that I sold Wednesday. After holding it as it fell $5, I did not want to watch it recover. My stop-buy was filled yesterday at 20.65.

Relatively quiet day today. Equity market is up again erasing yesterday's losses. So I sit and practice being patient.

MARKET POSITION: EQUITIES - SHORT (4 units); GOLD - LONG (1 unit)

Unconvinced

As I keep stating, I am unconvinced. Unconvinced that the credit crunch is over, unconvinced that the Fed lowering rates by 50 bps will solve the housing problem (which is at the root of the crisis), and unconvinced that the recent rally in the equity markets has legs. Perhaps I am stubborn, or wedded to my short position, but I don't think so. The more I think about it, the more unconvinced I become.

For risk management purposes, I entered 2 stop losses yesterday on my HXD position, for 1 unit at 19.90, and one unit at 19.80. The market gyrated between about 19.85 and 20.00 for the first 90 minutes. I thought I had outwaited the volatility, but not quite. My 19.90 stop was hit on the last move down through 19.90, then the stock subsequently rallied by about 50 cents (2nd stop was not hit).

Gold continued to rally so later in the day I placed a stop buy for one unit on HGU at 25.05 but this was not hit. Neither was my "re-enter" stop buy on one unit of HXD at 20.50.

Gold is through $730 today so I am a buyer of one unit of HGU at market (25.39). I also re-placed my re-entry stop buy for HXD at 20.65. CDN market continues to be quite weak and has fallen below my 13,900 upper target that I kept re-emphasising earlier this month. I think this may signal the final top of the rebound rally that began mid-August. Sentiment turned noticeably over-bullish after the Fed announcement. Most bears seemed to throw in the towel and assume risky assets were once again a safe bet. Reminds me of last June.

MARKET POSITION: SHORT EQUITIES (3 units); LONG GOLD (1 unit)

So Who's Right?

So who's right? The stock market or the Fed? The Fed cut rates by 50 bps yesterday due to concerns the recent credit crunch would adversly impact the real economy, and the stock market jumps over 2%. Does the stock market think that easy money is about to return? Or that inflation will be good for firm's pricing power? Or was it just caught up in the moment, and reality will soon bring it back to earth?

Either way, my upward bound for the TSX was breached yesterday, so I must seriously consider reducing my short position. However, as I have been burned many times entering and liquidating positions near turning points, I plan to wait until at least one hour after the open today to decide. Housing starts this morning were down more than estimates, and Morgan Stanley reported a 17% fall in earnings due to the credit crunch. Maybe these might remind investors what's really going on.

I also wish to establish an initial position in gold through HGU. Gold has gained strongly since I first mentioned it about a week ago. If the stock is up strongly more than one hour into trading, I will probably take a small position. I am slightly concerned about a small correction after the large gains of the past month, so I plan to enter this trade gradually.

MARKET POSITION: SHORT (4 units)

Testing Times

These are certainly testing times for anyone on the short side, such as myself. I think a lot of shorts have been shaken out over the past 2 weeks. I have held on due to my firm beliefs in the fundamentals, but good risk management practices dictate that I should consider reducing my position if the markets continue to rise from here. My sense is that we are probably near the end of this rebound rally, but I said that last week too. But rallies and declines usually end with a bang (I certainly re-learned that lesson when I sold additional units at almost the bottom of August's decline), and today's sharp rally certainly has that feel to it. I have continually said that my target range for the TSX rebound was 13,550 - 13,900. Today we reached 13,895.

Tomorrow will be a major test. Retail sales data for August will give a hint as to whether the American consumer still has some spending power up his/her sleeve, and whether people were spooked at all by the credit turmoil.

MARKET POSITION: SHORT (4 units)

Short Side Lining Up Nicely

The TSX appears to have spent the past four days forming a top to its pullback and the short side is now lining up nicely. Last week I mentioned that my level of uncertainty seemed greater than usual but I can safely say that I no longer feel that way. I would cite the following five factors:

1) Economy: last Friday's NFP report confirms what I have been saying for a while -- the economy is weak. The US housing market is very slowly falling off the edge of a cliff, and this will have major implications for households and the financial sector. The odds of a recession are now high -- certainly above 50%. Hell, there may be a recession underway already. A cut in the Fed Funds is now gauranteed, but as I said last week, it will be too late.
2) Market Sentiment: has shifted from overconfidence to hope. Everyone is now hoping that the Fed will save the market and the economy. That is the classic sign of the early stages of a bear market. Nevertheless, the bears remain wary. They are scared that the Fed will cut and the market will rally strongly. My investigations (admittedly anecdotal) are that there are not a lot of net shorts out there. That is a good sign from a contrarian perspective.
3) Financial Flows: The first week back after the summer was not good from a financial flow perspective. It seems that few deals were done. Everyone is edgy, and investors are not committing new money. The M&A market is quiet. Banks are stuck with lots of PE loans that they cannot unload and will have to carry on their balance sheets. LIBOR is ticking up as the financial system is icing over, despite all the money injected by central banks
4) Treasuries: Treasuries are rallying strongly. I was worried last week that the longer end of the curve was not coming down. Since then, the US 10 year yield has fallen by 15 bps. Impressive.
5) Gold: Over the past 8 months or so, gold has been stuck in a band between about $640 and $700. In general, it fell when risky assets fell, as investors treated it like other risky assets. But over the past couple of weeks, gold has increased sharply, and it breached $700 last Friday. And this despite the fact that the economy appears weak and commodities are not very strong, so inflation should not be a big concern. This may indicate that investors are becoming worried about the US financial system, and believe that the Fed is going to have to create LOTS of money to bail it out, putting more downward pressure on the USD.

If the market continues to fall I may add to my short position in the near future, keeping in mind rule #2. I will also considering taking a long position in gold, using the Horizons Betapro Gold Bull fund (HGU).

MARKET POSTIION: SHORT (4 units)

Fed Shmed

A couple of weeks ago I speculated that we may come to a point where the Fed cuts rates but then the market realises that the economic outlook is poor, leading to further market declines. The probability of this scenario occurring appears to be rising. The Fed looks like it will cut later this month but it will cut because it is concerned about the economy, not because it wants to prop up asset prices. In fact, from the snippets of Bernanke’s speech I have read, the Fed is becoming very concerned about the economy. It realises that falling housing prices will probably impact consumer spending. It also realises that credit conditions are tightening, and lower interest rates are needed to neutralise that impact, and possibly reverse it.

But all of this does not really matter. Why? Because the Fed is behind the curve. If there is going to be a recession later this year, or early next year, the Fed is already too late. Monetary policy operates with long and variable lags. All the Fed can do is try to ensure that any upcoming recession is not too long or too severe. I think the Fed knows this too.

MARKET POSITION: SHORT (4 units)